a forum for news, ideas and commentary on the art and science of long-term investing

Game Theory, Behavioral Finance, and Investing: Part 4 of 5

In earlier installments of this article, I have discussed some behavioral biases that tend to influence people to make bad investing decisions. In this post, I explore several more of these biases. The focus of this piece is on how we perceive ourselves and our ability to make independent decisions. One of the key ideas within rational markets is that people gather public information and make informed decisions. Without rational market participants, it is unlikely that markets themselves will converge to appropriate prices for traded assets (stocks, bonds, real estate, etc.).

Knowing the Difference Between Skill and Luck

This is, in fact, another case of attribution bias and can be summed up very easily: don’t decide that you are a brilliant investor because you thrive in a bull market. This is often referred to as the self-attribution bias, thinking that your successes are due to your special abilities when they may be, in fact, due to chance. There is an enormous body of research that shows that investors are far too confident in their own abilities to select investments and time the market.

Another area in which investors tend to have trouble distinguishing luck from skill is in the performance of mutual fund managers. Investors who are willing to pay high expense ratios in actively managed funds must do so because they believe that the managers of these funds have real skill that justifies the cost. Research on this topic suggests that a small number of fund managers do appear to have skill, but that it is highly unlikely that investors will be able to identify these managers ahead of time. This difficulty does not discourage the multitude of investors who choose actively managed funds in the hope that they will have found a manager who can deliver out-performance.

Herd Behavior

One of the most powerful of all behavioral biases is herd behavior—when people do something primarily because every else does it. This is also referred to as the ‘madness of crowds,’ a term which originated in the title of a book published in 1841 titled Memoirs of Extraordinary Popular Delusions and the Madness of Crowds. This book (available free by following the link) is a very readable exploration of a range of bubbles and manias and provides numerous examples in which entire nations have been swept up in the search for a quick and effortless gain. The really dangerous part of such bubbles is that they are self-perpetuating. If you buy stock X and everyone else decides that they want to own this stock, you will make considerable money by selling and thereby confirm that the stock was a great investment.

Herd behavior provides considerable opportunities. For example, eBay’s (EBAY) share price has increased more than threefold since 2009 but the stock still sells for a fairly modest P/E of 17. The ‘herd’ is no longer enamored with eBay. Over the last several years, eBay has been a very low-priced stock and it seemed that the market took a dim view of its earnings potential, despite solid performance. There are numerous other examples of individual companies and whole asset classes becoming ‘unpopular,’ which in turn drives prices down. To take advantage of such mis-pricing, however, you have to have the confidence to go against the crowd. The challenge, of course, is knowing when your commitment to bet against the crowd is not based on an over-estimation of your own skill.

Envisioning Your Future Self

A range of studies document that people save far less for retirement than most estimates suggest they should. Ending up old and poor will be miserable, so why don’t people save more. One compelling study of this problem concludes that people don’t save enough because they have trouble envisioning and relating to their future (older) selves. By showing people age progression pictures of themselves, they tended to save more for the future.

The psychological research behind this study suggests that many people simply cannot relate to the idea of their future selves. To many people, the future self is like a different person entirely:

Research has demonstrated that people make attributions about the future self in the same manner that they do for others, by attributing the future self’s behavior to dispositional factors rather than situational ones (Pronin and Ross 2006; Wakslak, Nussbaum, Lieberman and Trope 2008), and make decisions for the future self using a similar process that they use to make decisions for other individuals (Pronin, Olivola, and Kennedy 2008)

Why deny yourself today to save for some future person? In essence, your current self is competing for consumption with your future self.

Saving for the future is simply a form of delayed gratification, but many people apparently do not feel this way. There is little question, however, that these same people are likely to feel considerable regret in later life at not having saved more.

What It Means

In this article, I have focused on problems that arise from people having an incorrect or biased view of themselves (current and future). We like to think of ourselves as skillful and original, but we can’t all be above average. To a large extent, we simply choose to believe what we want to believe. We want to be able to spend more money today rather than saving for a day far in the future. We want to believe in some investment miracle that we can just jump on board with and that is as easy as doing what we other people are doing. The challenge is in asking ourselves whether our perception of reality is based on wishful thinking.

Challenging our natural biases in these areas requires a conscious effort. The specific behavioral biases that I have identified here are relevant to areas of life far beyond investing. Personal discipline in what we eat, how much we exercise, and other areas is largely motivated by having a vision of what will befall us if we don’t make the right choices. Being able to resist the herd in investing is not all that different from resisting peer pressure to drink or smoke in high school.

About Geoff Considine

After earning his Ph.D. in Atmospheric Science, Geoff worked for NASA for 3 years, leaving to become a quantitative analyst developing trading and portfolio management solutions for Aquila Energy. Leaving Aquila in 2000, Geoff became a consultant focusing on quantitative methods in portfolio management. Geoff founded Quantext in March 2002.
Geoff has published commentary and analysis in a range of publications, including Advisor Perspectives, Financial-Planning.com, and Horsesmouth.com.
Quantext is a strategic adviser to FOLIOfn,Inc. (www.foliofn.com (http://www.foliofn.com)).
Neither Quantext nor Geoff Considine is an investment advisor.

What Type of Investor Are You?

Understanding your investing profile to achieve your financial goals starts with a few simple questions. The Investor Questionnaire, by Folio Investing, will help you understand your investment time horizon, investor profile and level of risk.